The Advantages of Combining Momentum and Equal Weighting

Value has long been known as a counter to growth in the investing world. The folks at S&P Dow Jones Indices have recently pointed out another odd couple: equal weight and momentum.

Equal-weight strategies assign the same portfolio weighting to all stocks. The S&P 500 Equal Weight index rebalances quarterly to a 0.2% position for each of its 500 stocks.

Momentum strategies hold outperforming stocks and avoid underperforming stocks. The S&P 500 Momentum index holds the 100 stocks in the S&P 500 index with the highest 12-month relative strength. These are the stocks that have realized the highest returns relative to the S&P 500.

Momentum strategies shed the stocks with the worst relative strength and replace them with the current top-performing stocks at each rebalancing interval. Equal-weight strategies pare their largest positions (which are also the best-performing stocks) at each rebalancing interval and buy additional shares of the worst-performing stocks.

Put another way, momentum strategies rebalance into winners. Equal-weight strategies rebalance into losers. This difference causes one strategy to zig when the other zags. It makes the two strategies good portfolio partners for those seeking to diversify by style.

Equal-weight strategies expose investors to the size factor. By design, smaller companies have as much influence on returns as larger companies do. According to S&P Dow Jones Indices, the S&P 500 Equal Weight “has close to 80% of its weight in the smallest 400 companies of the S&P 500,” compared to only 27% for the market-capitalization-weighted benchmark.

Going back to our comparison, the median market cap of the S&P 500 Equal Weight was $36.3 billion at the end of July. The median market cap was $72.1 billion for the S&P 500 Momentum.

A big part of the difference relates to the current concentration of the overall S&P 500. The 10 largest stocks in the S&P 500 had a combined 34.4% weighting at the end of July. Because most of these stocks are also the S&P 500’s best performers, they have an outsized allocation in the S&P 500 Momentum. The combined weight of the 10 largest stocks in the S&P 500 Momentum was 64.7% at the end of July.

The combined weight of the 10 largest stocks in the S&P 500 Equal Weight was just 2.5% as of July 31.

There is nothing stopping momentum strategies from equal weighting their portfolios. If they were drawing from the same universe, there could still be an anti-size effect from equal weighting. The selected stocks for the momentum strategy would be the ones incurring largest relative gains in market cap.

If you were to hold the Invesco S&P 500 Equal Weight ETF (RSP) and the Invesco S&P 500 Momentum ETF (SPMO) in the same portfolio, you’d want to establish some type of rebalancing strategy between the two. It could be time-based (e.g., annually) or threshold-based—e.g., when one exchange-traded fund’s (ETF) allocation becomes 10% larger than the other’s. You could also combine other momentum-focused ETFs with the Invesco Russell 1000 Equal Weight ETF (EQAL) to draw from a larger universe of stocks.

An alternative is to combine momentum and/or equal-weight ETFs with a traditional market-cap-weighted index. Doing so would give you a smaller tilt away from the market portfolio, making the impact less influential.

I personally own the Invesco Russell 1000 Equal Weight in my Roth individual retirement accounts (IRAs) as well as in my taxable brokerage account. (I also have a very small position in the Invesco S&P 500 Equal Weight related to previous tax-loss harvesting.) I am market-cap agnostic when it comes to investing in individual stocks, and the Invesco Russell 1000 Equal Weight better reflects my approach. Plus, equal-weight strategies have outperformed the market-cap-weighted indexes over the long term.